Hedge Funds With(out) Edge
56 Pages Posted: 25 Jul 2023 Last revised: 16 Jan 2024
Date Written: July 18, 2023
Estimates of alpha from reduced-form factor models are an incomplete measure of hedge fund performance. By focusing solely on alpha, we are failing to capture important return variation during market dislocations. The omission of this return variation from performance measures leads to poor out-of-sample (OOS) performance. To address this issue, I introduce a new measure, Edge, and benchmark, Short VIX, of hedge fund performance that I argue more accurately reflects the skill of a hedge fund manager. A hedge fund manager that is able to generate alpha without exposure to market downside risks is determined to possess Edge. With the introduction of this measure, I document a new finding in the hedge fund literature: Hedge funds can be separated, ex-ante, into two groups, with respect to Edge. Only 3% of hedge funds possess Edge. OOS, hedge funds with Edge have both higher sharpe ratios and positive skewness while those hedge funds without Edge have lower sharpe ratios and negative skewness.
Keywords: Hedge Funds, Edge, Market Dislocations, Skill, Performance Evaluation, VIX Futures
JEL Classification: G11, G12, G14, G23
Suggested Citation: Suggested Citation